Capital Inflows and the Exchange Rate Alignments: The Cases of Asian Crisis Countries Prior to the Crisis

Transcription

1 Capital Inflows and the Exchange Rate Alignments: The Cases of Asian Crisis Countries Prior to the Crisis Rachda Chiasakul * Graduate School for International Development and Cooperation (IDEC), Hiroshima University, Kagamiyama, Higashi-Hiroshima , Japan This version: December 29, 2003 Paper submitted for consideration to be presented at the 8 th International Conference on Macroeconomic Analysis and International Finance May 2004 Department of Economics, University of Crete, Rythymno, Crete, Greece. *Corresponding author. Tel.: ; fax.: Address: rachda@hiroshima-u.ac.jp (R. Chiasakul)

2 Capital Inflows and the Exchange Rate Alignments: The Cases of Asian Crisis Countries Prior to the Crisis Abstract Indonesia, Korea, and Thailand experienced a surge in capital inflows in the 1990 s exceeding their current account deficits, a large portion of the capital inflow was short-term, and all four countries experienced a severe financial crisis. This study considers one the alleged fragilities, which is the exchange rate misalignment as one of the consequences of large capital inflow that led to the crisis. The main purpose of this study is to illustrate empirically whether or not and how a large capital inflow contributes to the exchange rate misalignments of the Asian crisis countries. According to the literature, capital inflow can create difficulties for recipient countries through real exchange rate appreciation. However, from the Granger causality test results, there was no clear causality from capital inflow to the price level, and the real effective exchange rate (REER) for Asian crisis countries during the period of capital inflow. This may due to the fact that availability of the exchange rate policy choice was limited for the Asian crisis countries, due to two main characteristics during the period prior to the crisis; 1) The Asian crisis countries had and still have a high degree of openness, which implies that the exchange rate policies in the Asian countries are interdependent with their neighboring countries exchange rate policies; And 2) countries experienced severe external balance of payments and debt crises in the 1980 s, they learnt that 1) Maintaining adequate international reserves could prove to be quite comforting for the emerging market countries in insulating the countries from external shocks. Therefore, as capital flowed in prior to the crisis, the crisis countries tended to engage in the exchange rate intervention mainly to acquire the international reserves, resulting in stable exchange rates; and 2) Real exchange rate appreciations per se can signal overvaluations. Therefore, the countries had been trying to maintain the real effective exchange rate fairly stable thereafter, until mid Keywords: Capital inflows, Real Effective Exchange Rate, Policy Behavior, Granger Causality Tests JEL Classification: F21, F31, F32, F41 1. Introduction The main purpose of this study is to illustrate empirically whether or not and how a large capital inflow contributes to the exchange rate misalignments of the Asian crisis countries. The countries included in the study are: Indonesia, Korea, and Thailand. The selection of countries is dictated by the severity of the crisis as compared to other Asian countries and the availability of the data. The time period covered in the study starts from early 1980 s to the beginning of the crisis at the end of However, it concentrates mostly on the period of vulnerability created by large capital inflow from the year of the surge of large capital inflow received by each country until capital inflow came to a halt in 1

3 the end of This study begins by exploring the previous literature on the main hypotheses that have been proposed about the mechanism of how capital inflow could contribute to the exchange rate misalignments. After that, it presents analytical framework and research hypotheses. Then, the methodology is specified, it follows by presenting results, and analysis. Finally, the study offers policy implication and recommendation for further study. 2. Literature review Frankel and Okongwu (1995) stated that capital inflows created some difficulties for recipient countries (nine Latin American and East Asian) through real appreciation of their currency, loss of competitiveness, and undermining of a strategy to achieve monetary stability by pegging the exchange rate. As also pointed out by Reissen (1999), and Bustelo, et al. (1999), temporary capital flows may lead to an unsustainable appreciation in real exchange rate. Mejia-Lopez (1999) also stated, under float exchange rate, capital inflow directly create nominal exchange rate appreciation. While under fixed exchange rates the authority can adopt some policy choice to accumulate international reserves. The more aggressive the accumulation, the lower the pressures on nominal exchange rate but the higher the pressures on the inflation In order to empirically illustrate that capital inflow could lead to real effective exchange rate appreciation a specific causality link shall be established from capital inflow to price level and real effective exchange rate. While there is overwhelming evidence that the large capital inflow did contribute to real exchange rate appreciation in Latin American countries (among other, Calvo, 2000), However, Athukorala and Rajapatiran (2003) pointed out that the degree of appreciation in real exchange rate associated with the capital inflow is uniformly much higher in Latin American countries compared to their Asian counterpart. According to Chinn (1998), the Asian crisis countries had overvalued exchange rates in the first quarter of Since the large capital inflow had been present for more than half a decade prior to the crisis, if it were to create the real effective exchange rate appreciation, the overvaluation should be observed before that time. Therefore, a careful observation of movement in the real effective exchange rate in Asian crisis countries during the period of capital inflow should be done. The other factors such as major currency exchange rate movements should also be considered. In addition, the issues of exchange rate policy, choice of exchange rate regime, and the underlying logic of such policies are crucial, since the exchange rate policy also determines how capital inflows influence the monetary sector and real sector. Under a fixed exchange rate regime, when capital flows in, monetary authority accumulates the international reserves and that results in an increase in monetary aggregates and an overheating economy. While under a floating exchange rate regime, capital inflow results in an exchange rate appreciation, and deteriorates current accounts. 2

4 Moreover, growing literature 1 addressing the issue of appropriate exchange rate regimes for reducing the risk of financial crisis tend to point toward a two-corner solutions approach. It suggests that the emerging market countries should adopt either hard pegs or free floating exchange rate regimes to avoid the financial crisis. Eichengreen and Hausmann (1999) documented three views of the relationship between exchange rate and financial fragilities that lead to the crisis. The first view emphasizes on moral hazards and the consequences of implicit guarantees. Pegged exchange rates are a form of implicit guarantee that promote unhedged foreign currency dominated debt, increase to fragilities, and made the country more likely to experience a crisis. In this view, not to peg the exchange rate is a natural choice. The second view emphasizes the incompleteness of financial markets, which they call original sin. It involves the situation when the national currency cannot be used by domestic entities to borrow abroad and cannot be used even at home for long-term borrowing. If the economy is having good economic prospects and a great degree of capital account convertibility, it will be attractive to the international investors, and domestic firms will have many projects that require financing. But since it cannot borrow in its own currency abroad, and cannot borrow in long-term, firms or financial institutes have to borrow in foreign currency or borrow in short-term. This leads to the currency and maturity mismatches. In this view, the country would be prone to the financial crisis in both pegged and floating exchange rate regime. The alternative policy implication is to dollarize, adopting hard pegged or currency board. Finally, the third view sees financial crises as a result of the weakness of the institution that address commitment problems. It views that the financial agreements sometimes are not self-enforcing. The natural policy implication is to strengthen the bankruptcy law, and improving the financial infrastructure. The implications for the exchange rate policy are less clear. However, according to Chang and Velasco (1998), when the monetary authority is a lender of last resort, the fixed exchange rate system can be more prone to bank runs and exchange rate crisis. While a flexible exchange rate system with policy by central bank to serve as lender of last resort can eliminates the risk of bank runs. According to Edwards and Savastano (1999), the real exchange rates are more likely to be out of line with their long-term equilibriums under fixed exchange rate regimes. However, according to McKinnon (1999),.before the currency attacks, the East Asian pegs to the dollar looked like good fixes with purchasing power parity, price level stability, and fiscal balance. The problem wasn t with their exchange rate policies but with the weak prudential regulation of their financial systems. In defense of the regulators, however, the resulting over borrowing was aggravated by the erratic behavior of the yen/dollar exchange rate and extremely low nominal interest rates on yen assets A careful examination of the actual exchange rate policy, and the underlying logic for the exchange rate policy choice of the Asian crisis countries should be conducted. 1 Among those support the super fixed exchange rate regime are; Calvo (1999), Hausman (2000) etc. The floating exchange rate regime supporters are; Chang and Velasco (1999), Edwards (2002), Velasco (2000), etc. 3

5 3. Analytical Frameworks and Research Hypotheses Lopez-Mejia (1999) stated that.under float exchange rate capital inflow directly creates nominal exchange rate appreciation. While under fixed exchange rates the authority can adopt some policy choice to accumulate international reserves. The more aggressive the accumulation, the lower the pressures on nominal exchange rate but the higher the pressures on the inflation.. Figure 3.1 shows the analytical framework for the mechanism between large capital inflow and exchange rate alignment. As shown, the direct impact of large capital inflow on real effective exchange rate is through nominal exchange rate appreciation. Without the intervention from monetary authorities, when capital flows in, the nominal exchange rate will appreciate. Figure 3.1: Large Capital Inflows and Exchange Rate Alignment Large Capital Inflow under Fixed Exchange Rate Consequences of Large Capital Inflow on Monetary Sector High Domestic Interest Rate and Lending Boom Increase in price index put pressure on monetary authority to increase interest rate Lending boom put Presure on asset price (nontradable) High interest rate curbing inflation (mostly tradable) Price Non-Tradable Goods Tradable Goods Real Effective Exchange Rate Direct Impact: Incase of manage float, without intervention, capital inflow leads to nominal (REER) Appreciation exchange rate appreciation. Overheating puts pressure on price Consequences of Large Capital Inflow on Real Sector Increase in aggregate demand Overheating Policy Response Monetary Policy Exchange Rate Policy Capital inflow also influences the exchange rate alignment through price. The price level is determined based on the interactions between the price level and other consequences of capital inflow (on monetary sector, and real sector). Lending boom as a consequence of capital inflow puts pressure on asset price, especially non-tradable goods. On the other hand, a higher price levels causes the monetary authority to increase the interest rate, and at the same time push down price levels. An overheating as a consequence of capital inflow puts pressure on price level both of tradable and non-tradable goods. However, the monetary and exchange rate policies responses to large capital inflow might have kept the price level and exchange rate in checked. In order to empirically illustrate that capital inflow could lead to real effective exchange rate (REER) 4

6 appreciation; specific causality link shall be operationalized from capital inflow to price level and real effective exchange rate. Moreover, certain external factors and policy that influenced REER should be examined. Moreover, a careful examination of the actual exchange rate policy, and the underlying logic for the exchange rate policy choice of the Asian crisis countries should be done. 4. Methodology Granger causality tests are performed to describe the linkage between the capital inflows and consumer price index as well as the real effective exchange rate so as to illustrate the causal link between capital inflows and REER appreciation. Augmented Dickey-Fuller Test results are shown in table 4.1, all variables are I(1), therefore the first differences is used in the Granger causality tests. Moreover, certain external factors that influence REER will be critically analyzed and finally the analysis will determine if external factors could result in REER appreciation. A careful examination of the actual exchange rate policy and the underlying logic for the exchange rate policy choice of the Asian crisis countries is made concerning two issues; 1) what were the actual exchange rate regimes and the exchange rate policies in response to the large capital inflow in the Asian crisis countries; and 2) what was the underlying logic for the exchange rate policy choice. Apart from the announced exchange rate regimes of Asian crisis Countries, Reinhart, and Rogoff (2002) suggested that the actual exchange rate policies taken by countries may have differed from their announced regime. Calvo and Reinhart (2000) analyzed the behavior of exchange rates, reserves, monetary aggregates and interest rates across 154 exchange rate arrangements and found that the countries that have announced managed floats or floating exchange rate regimes may not actually allow their exchange rate to float. They calculated the percentage changes in countries exchange rates, reserves, monetary aggregates and interest rates. They then assigned a critical threshold that the rates of changes in each indicator should fall into and calculated the actual probability the changes in those indicators would fall into the threshold. For example, for the threshold of -/+ 1%, most of the countries that have announced fixed exchange rate regime should have their exchange rate changes fall within the -/+ 1% threshold. While the changes in their international reserves, monetary aggregates, and interest rates should fall outside -/+ 1% threshold or fall in the wider range threshold. In order to illustrate the actual exchange rate policy taken by the Asian crisis countries, this study calculates the probabilities of changes indicators stated above in four Asian crisis countries that fall within different threshold and also compare them with the probability of those for the cases of Japan and the US. 5

7 Table 4.1: Augmented Dickey Fuller Unit Root Tests for Capital Account, Consumer Price Index, and Real Effective Exchange Rate I(0) I(1) Countries Variables ADF Test Statistic 1% Critical Value* ADF Test Statistic 1% Critical Value* Unit Root(s) Sample: 1980:1 1989:4 Indonesia Korea Thailand Indonesia Korea Thailand KA I(1) CPI I(1) REER I(1) KA I(1) CPI I(1) REER I(1) KA I(1) CPI I(1) REER I(1) Sample: 1990:1 1996:4 KA I(1) CPI I(1) REER I(1) KA I(1) CPI I(1) REER I(1) KA I(1) CPI I(1) REER I(1) 5. Results and Analysis As can be seen in tables 5.1 and 5.2, there is no clear causality from the capital inflow to the consumer price index and the real effective exchange rates during the period of large capital inflows. 6

8 Table 5.1: Pairwise Granger Causality Test Results Between Capital Account And Consumer Price Index (CPI) Pairwise Granger Causality Test Result between Capital account and Consumer Price Index Sample: 1980:1 1989:4 Capital Account does not Granger Cause CPI Reject** Indonesia CPI does not Granger Cause Capital Account Accept Sample: 1990:1 1996:4 Capital Account does not Granger Cause CPI Accept CPI does not Granger Cause Capital Account Reject* Sample: 1980:1 1989:4 Capital Account does not Granger Cause CPI Accept Korea CPI does not Granger Cause Capital Account Accept Sample: 1990:1 1996:4 Capital Account does not Granger Cause CPI Accept CPI does not Granger Cause Capital Account Accept Sample: 1980:1 1989:4 Capital Account does not Granger Cause CPI Accept Thailand CPI does not Granger Cause Capital Account Accept Sample: 1990:1 1996:4 Capital Account does not Granger Cause CPI Accept CPI does not Granger Cause Capital Account Accept Note: The appropriate lag length of each model was determined based on Akaike Information Criterion 7

9 Table 5.2: Pairwise Granger Causality Tests between Capital Inflow and Real Effective Exchange Rate (REER) Pairwise Granger Causality Test Result between Capital account and Real Effective Exchange Rate (REER) Sample: 1980:1 1989:4 Capital Account does not Granger Cause REER Reject** Indonesia REER does not Granger Cause Capital Account Accept Sample: 1990:1 1996:4 Capital Account does not Granger Cause REER Accept REER does not Granger Cause Capital Account Accept Sample: 1980:1 1989:4 Capital Account does not Granger Cause REER Accept Korea REER does not Granger Cause Capital Account Accept Sample: 1990:1 1996:4 Capital Account does not Granger Cause REER Reject* REER does not Granger Cause Capital Account Accept Sample: 1980:1 1989:4 Capital Account does not Granger Cause REER Reject** Thailand REER does not Granger Cause Capital Account Accept Sample: 1990:1 1996:4 Capital Account does not Granger Cause REER Accept REER does not Granger Cause Capital Account Accept Note: The appropriate lag length of each model was determined based on Akaike Information Criterion The real effective exchange rates during the period of large capital inflows into the Asian countries currencies could not be much over valued but rather undervalued, since the countries need to promote their exports. Figure 5.1 shows that the real effective exchange rates of East Asian countries were quite stable until mid They started to appreciate slightly after the US $ started to rise against Japanese Yen. In addition, as mentioned earlier in the section addressing policy responses to capital inflow, it seems that the monetary authorities imposed tight monetary policies in coping with the net monetary effect of large capital inflow and combating the overheating economy 2, therefore, keeping the inflation rates in check. 2 See Chiasakul (2003) on monetary policy response to capital inflow in Asian crisis countries. 8

10 Figure 5.1: Real Effective Exchange Rate (REER) Real Effective Exchange Rate (REER) Jan-90 May-90 Sep-90 Jan-91 May-91 Sep-91 Jan-92 May-92 Sep-92 Jan-93 May-93 Sep-93 Jan'94 May-94 Sep-94 Jan-95 May-95 Sep-95 Jan-96 May-96 Sep-96 Thailand Indonesia Rep. of Korea Source: see Appendix A Japanese Yen:US$ (secondary axis) The issues of actual exchange rate policies taken are very crucial. The announced exchange rate regimes during the period of , for Indonesia and Korea were the managed floating exchange rate regimes. (For Indonesia since 1983, the Bank of Indonesia adopted the managed float policy and revised it in 1989, though still under managed float principle. For Korea, a multiple currency peg system was introduced in March 1980; it then started allowing the Korean Won to fluctuate within a percentage range in 1989 and finally in March 1990 there was a managed floating exchange rate regime. 3 ). For the case of Thailand, following the IMF classification, its currency was considered to be pegged to composite basket of currencies. During the period from , though the basket of currencies was revised twice between the years 1984 and However, the exchange rate regimes for the countries under this study during the period of capital inflow ( ) were characterized as de facto pegged or de facto crawling pegged (among others Reinhart and Rogoff (2002). Also in the study by Calvo and Reinhart (2000), though not directly focusing on the period of this analysis, their results of exchange rate volatility and other indicators indicated that the crisis countries during the pre-crisis period heavily intervened in the foreign exchange market. Following Calvo and Reinhart (2000) 4, in order to illustrate the actual exchange rate policy taken by the Asian crisis countries, this study calculated the probabilities of the changes in the indicators stated above in four Asian crisis countries that fall within different thresholds and also compared them with the probability of those for the cases of Japan and the US. 3 Source: See appendix. 4 Though different time period were used 9

11 In figure 5.12, it is shown that there was a very high probability that changes in Asian crisis countries exchange rates fell within a very small range (+/- 1%) and almost a 100% probability that the changes in exchange rate fell with in +/-2%. As compared to the case of the US and Japan, the exchange rates of Asian crisis countries seemed to be very stable during the period of large capital inflows. In addition, the fluctuation of their International reserves, monetary base, and interest rates seemed to fluctuate a lot. The results of exchange rate volatility, and other indicators indicated that the crisis countries during the pre-crisis period heavily intervened in the foreign exchange markets. Table 5.3: Fear of Floating Fear of floating US Japan Indonesia Korea Thailand Probability of Fluctuation in Exchange rates Probability of Fluctuation in International Reserve Probability of Fluctuation in Monetar Base fall with in +/- 1% 39.29% 34.52% 97.62% 85.71% 96.43% fall with in +/- 2.5% 69.05% 67.86% % % % fall with in +/ % 58.33% 33.33% 23.81% 26.19% fall with in +/ % 78.57% 52.38% 57.14% 60.71% fall with in +/ % 27.38% 16.67% 16.67% 14.29% fall with in +/ % 47.62% 40.48% 36.90% 52.38% Probability of Fluctuation in Interest Rates Source: IMF (2002), and author s own calculation fall with in +/ % 94.05% 44.05% 40.48% 15.48% fall out side +/ % 0.00% 4.76% 0.00% 4.76% fall out side +/ % 0.00% 4.76% 0.00% 1.19% Underlying Logic for the Exchange Rate Policy Choices As mentioned by Goldstein (1995), the authorities in Asian financial crisis countries responded to the influx of international capital inflow in various ways. As capital flew in there are various macroeconomic policies e.g. fiscal, monetary, and exchange rate policies to choose from, depending on the characteristic and objective of each country. Given de facto pegged exchange rate regime, and high capital mobility, according to the application from standard Mundell-Fleming model, fiscal measures would be the most appropriate policy measure to combat overheating effects of large capital inflow. From the experience of Asian crisis countries prior to the crisis during the period of large capital inflow, strong fiscal discipline had been maintained. However, the requisite political support for fiscal contraction might have been too much to ask for. If the authorities would let domestic currency to appreciate as capital flew in, macroeconomics impact of capital inflow could have been minimal. However, as will be discussed in the following argument, an exchange rate appreciation is inconceivable given the historical background of the countries 10

12 and when countries depend largely on export sector. Meanwhile, as exchange rates were de facto pegged, tight monetary measures were also taken to combat further overheating consequences of capital inflow, which kept the domestic interest rates at quite high level 5. This in turn invited more capital inflow. With the limitation of both fiscal and monetary policy, it seems that of Asian crisis countries could have let currencies to appreciate in order to resist adverse overheating consequences of capital inflows. However, the availability of the exchange rate policy choice is also limited, due to two main characteristics during the period prior to the crisis; 1) The Asian crisis countries had, and still have a high degree of openness The high degree of trade openness not only indicates the overwhelming independence from the export sectors, it also implies that the exchange rate policies in the Asian countries are interdependent with their neighboring countries exchange rate policy. The natural exchange rate policy choices are; 1) to keep their exchange rates fairly stable to the dollar in order to insulate each other from beggar-thy neighbor devaluations ; and 2) to resist real exchange rate appreciations in order to protect the export sector. In addition, as the US$ was continuously depreciating against Japanese Yen until mid-1995, to keep pegging the exchange rate with the US$ was desirable to maintain the countries competitiveness. 2) The countries experienced severe external balance of payments and debt crises in the 1980 s The lessons learnt by the countries during the 1980 s crises are at least 1) Maintaining adequate international reserves could prove to be quite comforting for the emerging market countries in insulating the countries from external shocks. Therefore, as capital flowed in prior to the crisis, the crisis countries tended to engage in the exchange rate intervention mainly to acquire international reserves, resulting in stable exchange rates; and 2) Real exchange rate appreciations per se can signal overvaluations. From figure 5.12, the Asian crisis countries experienced real effective exchange rate appreciations in the early 1980 s and the appreciations preceded a sharp depreciation and the crises. Since then, the countries had been trying to maintain the real effective exchange rate fairly stable until mid The real question may be, why were the slight real effective exchange rate appreciations allowed from mid-1995? As mentioned earlier, the real effective exchange rate appreciations were a result of the fluctuation in two major currencies namely the US$ and the Japanese Yen. With their large volume of trade with the Japanese Yen and relatively small weight of Japanese Yen in the currencies baskets, the real effective exchange rates were appreciating as the US$ appreciated against the Japanese Yen. With the benefit of hindsight, to be consistent with the exchange rate policy implicitly maintaining the stable real effective exchange rates, the authorities should have reevaluated their currencies baskets. However, the fluctuations of two major currencies could have been interpreted as a temporary phenomenon and the decisions regarding exchange rate policies involve sensitive economic and political consequences. 5 See Chiasakul (2003) on the consequences of large capital inflow on domestic interest rates. 11

13 Figure 5.2 Historical Real Effective Exchange Rates (REER) INDONESIA KOREA Jan-79 Jan-81 Jan-83 Jan-85 Jan-87 Jan-89 Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-79 Jan-81 Jan-83 Jan-85 Jan-87 Jan-89 Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 THAILAND Jan-79 Jan-81 Jan-83 Jan-85 Jan-87 Jan-89 Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Source: See Appendix The Asian crisis countries tried to resist the REER appreciation regardless of the announced exchange rate regime because of their high degree of openness and their experience in 1980 s. The exchange rate policy response to large capital inflow also related to the monetary policies and the weaknesses in both monetary and real sectors. The de facto dollar peg policy implies a more aggressive accumulation of monetary authorities net foreign assets. While the tight monetary policy response to the consequences of large capital inflow kept the domestic inflation in checked, which also kept the REER in checked. All in all, this resulted in excessively high domestic interest rates, which weaken the domestic financial sector. 6. Conclusions Indonesia, Korea, Malaysia and Thailand experienced a surge in capital inflow in the 1990 s exceeding current account deficit a large portion of the capital inflow was short-term, and all four countries experienced a severe financial crisis. This paper considers one the alleged fragilities, which is the exchange rate misalignment as one of the consequences of large capital inflow that led to the crisis. Important findings of this paper can be summarized as follows: Capital inflow can create difficulties for recipient countries through real exchange rate appreciation. However, from the Granger causality test results, there was no clear causality from capital inflow to the Price level, and the real effective exchange rate during the period of capital inflow. In addition, the real effective exchange rates during the period of large capital inflow the Asian countries currencies could not be much overvalued but rather undervalued, since the countries needed to promote their exports. They 12

14 started to appreciate slightly after the US$ stated to rise against Japanese Yen. The exchange rate misalignment or real effective exchange rate appreciation, if there were any prior to the crisis, were resulted from fluctuation of US$ against Japanese Yen. The main implication should be that there is a need for more stability in the exchange rates of major currencies. Otherwise, the Asian crisis countries should have had more flexible exchange rate policies or better weight for Japanese Yen in their currency baskets. The issues of the actual exchange rate policies, the choices of exchange rate regime, and the underlying logic of such policies are crucial, since the exchange rate policy also determines how capital inflows influence the monetary sector and real sector. Under a fixed exchange rate regime, when capital flows in, monetary authority accumulates the international reserves and that results in an increase in monetary aggregates and an overheating economy. While under a floating exchange rate regime, capital inflow results in an exchange rate appreciation, and deteriorates current accounts. Following Calvo and Reinhart (2000), in order to illustrate the actual exchange rate policy taken by the Asian crisis countries, this study calculated the probabilities of changes in various indicators in four Asian crisis countries that fall within different thresholds and also compared them with the probability of those for the cases of Japan and the US. The results showed that as compared to the cases of the US and Japan, the exchange rates of Asian crisis countries seem to be very stable during the period of large capital inflows. In addition, the fluctuation in their International reserves, monetary base, and interest rates was apparent. The results of exchange rate volatility, and other indicators indicated that the crisis countries during the pre-crisis period heavily intervened in the foreign exchange markets. Given de facto pegged exchange rate regime, and high capital mobility, according to the application from standard Mundell-Fleming model, fiscal measures would be the most appropriate policy measure to combat overheating effects of large capital inflow. Strong fiscal discipline had been maintained. However, the requisite political support for fiscal contraction might have been too much to ask for. Tight monetary measures were also taken to combat further overheating consequences of capital inflow, which kept the domestic interest rates at quite high level. This in turn invited more capital inflow. With the limitation of both fiscal and monetary policy, it seems that Asian crisis countries could have let currencies to appreciate in order to resist adverse overheating consequences of capital inflows. However, the availability of the exchange rate policy choice was also limited for the Asian crisis countries, due to two main characteristics during the period prior to the crisis; 1) The Asian crisis countries had and still have a high degree of openness; and 2) countries experienced severe external balance of payments and debt crises in the 1980 s. While the high degree of trade openness not only indicates the overwhelming independence to export sectors, it also implies that the exchange rate policies in the Asian countries are interdependent with their neighboring countries exchange rate policies. The natural exchange rate policy choices are; 1) to keep their exchange rates fairly stable to the dollar in order to insulate each other from beggar-thy neighbor devaluations ; and 2) to resist real exchange rate appreciations in order to protect the export sector. In addition, the lessons learnt by the countries during the 1980 s crisis are 1) Maintaining adequate international reserves could prove to be quite comforting for 13

15 the emerging market countries in insulating the countries from external shocks. Therefore, as capital flowed in prior to the crisis, the crisis countries tended to engage in the exchange rate intervention mainly to acquire the international reserves, resulting in stable exchange rates; and 2) Real exchange rate appreciations per se can signal overvaluations. Therefore, the countries had been trying to maintain the real effective exchange rate fairly stable thereafter. For a final note, with the benefit of hindsight, the real question arises from the study might not be what is the most appropriate exchange rate regime? but could Asian crisis nations effectively resist the adverse effect of large capital inflow? given their limited macroeconomic policy choices. The hints may lie upon addressing prudential regulation of the financial systems. A more unorthodox approach, one might have asked if export led growth and capital inflow led growth strategies are the optimal policies. Appendix: Data Real effective exchange rates (REER) ( ) (for the cases of Indonesia and Thailand.) For the case of Korea, the presented REER is a result of author s combining data replicated from Cho (1996), and from ADB ( Historical Exchange Rate Regimes The data from IMF, International Financial Statistics, December 2002 CD-ROM Capital inflow (KA)line 78BCDZF Inflation rate, Price (P, P*): Consumer price index, IFS line 64X, Percentage change over previous year calculated from indices (1995=0) References Athukorala, Prema-chandra, and Surath Rajapatirana Capital Inflows and the Real Exchange Rate: A Comparative Study of Asia and Latin America. The world Economy. Vol. 26. No. 4, pp Bustelo, Pablo, Clara Garcia, and Iliana Olivie Global and domestic factors of financial crises in emerging economies: Lessons from the East Asian episodes ( ). Universidad complutense de Madrid, Instituto Complutense de Estudios Internacionales working paper, November. Calvo, Guillermo A Balance-of-Payments Crises in Emerging Markets: Large capital Inflows and Sovereign Governments, in, Krugman, Paul. Eds. Currency Crisis. University of Chicago Press, pp , and C. M. Reinhart Fear of Floating, NBER Working Paper No Chang, Roberto and Andres Velasco Financial Fragility and the Exchange Rate Regime. NBER Working Paper No Liquidity Crises in Emerging Markets: Theory and Policy. NBER working paper

16 Chinn, Menzie D Before the Fall: Were East Asian Currencies Overvalued? NBER Working Paper No Chiasakul, Rachda, Monetary Policy Responses to Large Capital Inflows and Domestic Interest Rates: The Case of Asian Crisis countries prior to the crisis, Journal of International Development Studies. Vol. 12, No.1, pp Cho, Donchul Exchange Rate Movements in Korea: Evaluation and Policy Implications, Korean Development Institute (December). Eichengreen, Barry, and Ricardo Hausmann Exchange Rates and Financial Fragility. NBER Working Paper No Edward, Sebastian Exchange Rate Regimes in Feldstein, Martin Eds. Economic and Financial Crises in Emerging Market Economies. The University of Chicago Press., and Miguel A. Savastano Exchange Rates in emerging economies: What do we know? What do we need to know? NBER Working Paper no. W Frankel, Jeffrey, and Chudozie Okongwu Liberalized portfolio capital inflows in emerging markets: sterilization, expectations and the incompleteness of interest rate convergence. National Bureau of Economic Research Working Paper No International Monetary Fund International Financial Statistic, The IMF. López-Mejía, A Large Capital Flows: A survey of the causes, consequences, and policy responses. International Monetary Fund Working Paper No. 99/-17. February. McKinnon, Ronald I The East Asian Dollar Standard, Life After Death. Workshop on Rethinking the East Asian Miracle for Economic Development Institute (EDI) World Bank at The Asian Foundation San Francisco, California, February 16-17, Reinhart, C. M., and K. S. Rogoff The Modern History of Exchange Rate Arrangements: A Reinterpretation. National Bureau of Economic Research Working Paper No Reisen, Helmut Domestic causes of currency crises: policy lessons for crisis Avoidance. OECD- Development Center paper. Velasco, Andrés Exchange-Rate Policies for Developing Countries: What have we learned? What do we Still not know? G24 Discussion Paper No. 5 (June). 15